Introduction An emerging market is a nation with social or business activity in the process of rapid growth and industrialization EMERGING

mar ets! is a useful term precisely because it is imprecise" #oined for the convenience of investors loo ing for somewhere e$citing to put their money% it covers a bewildering range of economies with little in common% e$cept that they are not too rich% not too poor and not too closed to foreign capital" such countries are considered to be in a transitional phase between developing and developed status &he seven largest emerging and developing economies by either nominal or inflation'ad(usted G)* are the +RI# countries ,+razil% Russia% India and #hina-% as well as MI.& ,Me$ico% Indonesia% /outh'.orea and &ur ey-" Morgan /tanley0s Emerging Mar ets Inde$ consists of Argentina% +razil% #hile% #hina% #olombia% #zech Republic% Egypt% 1ungary% India% Indonesia% Israel% 2ordan% .orea% Malaysia% Me$ico% Morocco% *a istan% *eru% *hilippines% *oland% Russia% /outh Africa% &aiwan% &hailand% &ur ey and 3enezuela" *olitical scientist Ian +remmer defines an emerging mar et as 4a country where politics matters at least as much as economics to the mar ets4" several professors from 1arvard +usiness /chool and 5ale /chool of Management have described"In 6777% 4this Emerging mar et country is a society transitioning from a dictatorship to a free'mar et'oriented'economy% with increasing economic freedom% gradual integration with the Global Mar etplace and with other members of the GEM ,Global Emerging Mar et-% an e$panding middle class% improving standards of living% social stability and tolerance% as well as an increase in cooperation with multilateral institutions4 Data:8or more than two decades% emerging mar ets ,EMs- have generated some of the most e$citing investment opportunities globally" As economies in Asia% 9atin America and Eastern Europe began to grow at rates that far outpaced more developed countries% new economic reforms and trade liberalization opened the door to :estern investment" Meanwhile% increasing urbanization and a burgeoning middle class gave rise to a new generation of consumers with strong demand for consumer goods and infrastructure development to support their new lifestyles &he natural resource advantage 7;< of the world=s proven oil reserves are to be found in emerging mar ets" 9i ewise% commodities such as copper% gold and platinum are abundant in 9atin America" &hese riches have been successfully harnessed through the development of world'leading producers such as

#hile=s #odelco% and +razil=s 3ale" 9oo ing ahead% demand for raw materials is increasing in both emerging mar ets% as their population moves from rural areas into the city and necessitates the building of new infrastructure% and in the developed world% as ageing infrastructure is replaced" &he rise of the consumer society wealth in the emerging mar ets is on the increase" &he e$panding middle classes of the developing world are eager consumers% een to emulate western lifestyle% and so western companies are rapidly rolling out their brands to ta e advantage of this trend" 1owever% local competitors are also e$panding apace to cater e$clusively to the tastes of the emerging mar et consumer" Economic development indications Investments in emerging mar ets come with much greater ris due to political instability% domestic infrastructure problems% currency volatility and limited e>uity opportunities ,many large companies may still be 4state'run4 or private-" Also% local stoc e$changes may not offer li>uid mar ets for outside investors"

&he emerging mar ets ,EMs- have provided ma(or investment opportunities over the last decade ?whether in the e>uity% fi$ed income or currency spaces" &he global growth landscape and investment opportunity set have changed significantly in recent years% but allocating to emerging mar ets remains% a core investment strategy" As emerging mar et economies have grown and converged with their more developed counterparts% the long'time?and much trumpeted?EM diversification benefit for investors has% somewhat abated and diversification in itself no longer provides an ade>uate (ustification for investing in emerging mar ets" Emerging mar ets have come to more closely resemble their developed mar et ,)Mcounterparts?and accordingly% investors must drill down to the sector% company and security levels to achieve their investment goals" Inflation% income ine>uality and the interconnection of these two realities to social unrest still represent a significant long'term challenge to EM growth" 8aced with the prospects of rising rates or sputtering growth% many EM policyma ers will li ely allow for the appreciation of their currencies"

:e believe that there will be a switch over time from economic policies based on mercantilism and foreign e$change reserve accumulation towards domestically led growth" Among other issues that pose significant potential limits to ongoing growth are natural resource constraints% the middle'income trap%! volatile financial capital inflows% managed e$change rates ,and potential asset misallocation arising from this process- and shallow domestic financial mar et infrastructure" :e contend that% in general terms% these are constraints on medium'term growth rates and not insurmountable barriers" :e also see a ey trend in the deepening of domestic financial systems as welfare programs develop to meet the longer'term challenges of aging populations" )eeper domestic financial systems should provide greater ability to absorb challenges from short'term capital flows and the resulting macroeconomic volatilities" :hile a number of challenges loom% we believe that the emerging mar ets= share of world financial assets will increase materially over the ne$t decade both through price appreciation and capital issuance"" In short% by @;@; the investment world is e$pected to be spending even more time on the emerging mar ets than is the case today" In this new landscape% developments in +ei(ing% Mumbai and /ao *aolo will% in our view% re>uire as much study as those in New 5or % 9ondon and 8ran furt"

Present scenario &oday% however% EMs present a very different investment proposition% having established themselves as ma(or players in the global economy" #ompared to :estern countries% many emerging mar ets are better resourced% have stronger balance sheets and younger wor forces" #hina and India together comprise three times the population of the entire advanced world" Emerging mar ets now represent AB< of the world=s population% CD< of the world=s land mass and resources and account for D;< of world G)* at purchasing power parity ,***-% yet account for (ust 6@< of the global e>uity mar et capitalization on a float'ad(usted basis" Emerging mar ets% of course% come in many sizes and forms" &here are limited similarities between the financial structures and investment return drivers of a highly developed economy and financial system such as% say% /outh .orea and those of the frontier mar ets of Africa and #entral Asia" G)* per capita is in some cases higher in emerging mar et countries than in the poorer developed countries% so .orea and &aiwan% with G)* per capita of E@@%;;; apiece% have higher ratios than many European countries" Fn the other hand% there is a number of EMs with very low ratios% such as India% with G)* per capita of (ust E6%D;;" &he frontier countries are even more e$treme% ranging from the oil states of .uwait and Gatar?which is among the wealthiest in the world?to African states with G)* per capital of less than E6;;;" 1owever%

some of the poorest countries are also some of the fastest'growing globally" Fverall% emerging growth is significantly faster than in the developed world% but there are significant variations? ranging from Gatar% with forecasted G)* growth of @;< this year% to the #zech Republic% with forecasted growth of (ust over @<" &here are huge differences between Russia and +razil% which benefit from rising commodity prices and importers such as &ur ey and India% which struggle with rising prices" /o again% we have to be careful with generalizationsH .orea and &aiwan have economies that are closely lin ed to global growth% while India=s economy is much more driven by domestic factors" A slowdown in EMs is not the same as a slowdown in developed mar ets ,)Ms-" 8or #hina% a slowdown means going from 6;< growth to C'A<% while a @< slowdown implies a full'blown recession for many developed countries"EM demographic factors are much more positive than in developed countries% with younger and growing populations and% therefore% a growing wor force in contrast to the declining wor force and rising dependency ratios of the developed world" &his is especially the case in frontier mar ets such as in Africa% which have the youngest and fastest' growing populations" &he development of financial systems and the rule of law will also be ey to advances in emerging stoc mar ets" /ome countries have made good progress and score relatively highly in these two areas% such as &aiwan and 1ungary% while significant concerns remain about corruption and governance in places li e India and Russia" &his is fre>uently reflected in lower valuations in more corrupt countries% but also presents an opportunity for improvements% leading to higher standards and higher valuations" 9i>uidity is one of the criteria all investors should ta e into consideration" Fne factor is state ownership% which reduces the size of the free float and also affects standards of governance" In general% the largest mar ets have traditionally been the most li>uid?/outh .orea% #hina% +razil and &aiwan?while #olombia and *hilippines have been relatively illi>uid" 8rontier mar ets have been even more illi>uid% so investors should consider focusing on the largest companies in those mar ets% or they could consider a longer holding period" A related issue is the volatility of share prices?emerging mar ets remain significantly more volatile than developed mar ets% particularly in times of stress" /ome mar ets% of course% will eventually ascend to developed mar et status?.orea and &aiwan% for e$ample% are regularly reviewed for such a move" Many of the most e$citing opportunities now lie in the frontier countries% which are not included in today=s EM indices but which could be the emerging mar ets of the ne$t decade" A handful of emerging mar ets have deep domestic bond mar ets with fully developed yield curves?for e$ample% /outh Africa and India?whereas many other countries have very shallow domestic bond mar ets ,such as #hina-" 9i ewise% currency mar ets come in all shapes% sizes and form with pegged rates% crawling pegs% managed floats% partial floats and freely floating currencies? the latter% sadly% the least'common species" In more recent times% the period from the dawning of the Industrial Revolution in the I. around 6C;7 ,dated to the construction of a still'standing and remar able cast iron bridge across the Iron +ridge Gorge in /hrop shire- saw a considerable acceleration of the :est relative to the East"

8rom that time% the I/ and :estern Europe embar ed upon sustained and unprecedented rises in income per head and in productivity% and continued along that path for the better part of two centuries" Meanwhile% income per head in Asia actually declined% so that the difference between the richest countries and #hina fell to two to one" +y the middle of the @;th century% this discrepancy had grown to J; to one% e$acerbated by dreadful wounds such as the #ultural Revolution in #hina% the post'67KC *artition of India and the 3ietnam :ar" In 9atin America% the lost decades of hyper'inflation and military populism from 67D; until the early 677;s impeded development" Emerging Europe slumbered and decayed during the #old :ar%while Africa struggled to cope with the vicissitudes of the post'#olonial era" In short% the :est got luc y and the rest of the world did not" 1owever% since the mid'67A;s the tide% in our view% has turned% with the emerging economies surviving the wrenching financial crises that lasted from the devaluation of the Me$ican peso in )ecember 677K until the Argentinian devaluation of @;;6 to emerge with growing shares of world output and capital mar ets" In recent years% emerging mar et growth has outstripped the developed mar etsJ" 8igure 6 below charts emerging mar et versus developed mar et growth since 67A7 on a 6;'year trailing basis" In the =A;s% G)* growth in the developed and in the emerging worlds was essentially the same" +ut between @;;; and @;6;% average growth in the emerging world rose to the point where it was three times higher% driven largely by the Asian economies

Moreover% as emerging economies have grown% the output of developed economies has been shrin ing?a situation that is almost entirely e$plained by growth in Asia" &he IM8 data e$pressed as on the previous census asserts that from 677@ to @;6D% advanced countries are e$pected to decline by 6C< of total G)*?an unprecedented rate of deterioration" )eveloping Asia accounts for most of this drop% with growth e$pected to be 6A< within the same timeframe" &he rest of the emerging world=s weight in the world economy will remain roughly constant" &he e$port share for +razil underlines the emergence of a new core to the economic system" At the beginning of @;;6?(ust 6; years ago?the Inited /tates dwarfed #hina as a mar et for +razil" +ut in @;;7% #hina=s share began to e$ceed that of the I/% and #hina=s share of +razil=s e$ports is now up to 6D percent" &his is only B< less than the whole of the European Inion" If this trend

continues apace% #hina will be a more important mar et for +razil than the entirety of the European Inion within the ne$t five years" Demographics and economic factors /trong population growth has rapidly increased the number of people of wor ing age in these economies bolstered by the rapid urbanization of EM populations" &his e$panding wor ing population and the migration of rural wor ers into the cash economy in many EMs is also increasing the domestic consumer base ,8igure K-% thus setting the stage for private consumption growth that is ey as economies ma e the critical shift from e$ternal to internal demand to become self sustaining" As a result% many emerging mar ets are e$pected to become less reliant on e$ports as domestic demand becomes an increasingly significant growth engine /overeign debt levels around the world increased dramatically in response to the credit crisis of @;;A" Many countries intentionally pushed up their debt levels to fuel the aggressive fiscal and monetary response needed to avoid full'scale economic disaster" +ut with the worst of the crisis behind us ,we hope-% it is notable that sovereign debt concerns are mostly a developed mar et phenomenon ,8igure B-" Emerging mar et debt and deficit levels loo benign by comparison?compare 2apan=s @@;<D debtLG)* ratio to India=s% the most debt'laden +RI# country% at B7<D" 8urther% while budget deficits are forecast to diminish globally over the ne$t five years% developed mar ets should continue to carry more debt than emerging ones" &his balance'sheet strength is due in large part to lower levels of consumer and government leverage" :hile the ban ing sectors in the I/ and Europe have been severely impacted by the subprime debt mar et collapse% those in emerging mar ets had very little e$posure to this contagion" As a result% EM ban s have been generally well capitalized% unencumbered by the lending constraints that remain evident in the developed world Emerging Mar ets 1ave Made &remendous *rogress )uring the 677;s% a wave of reforms was implemented in many emerging economies in line with the so'called :ashington #onsensus%! which encompassed ideas about liberalization% privatization and fiscal discipline" 9atin America undertoo the most comprehensive reform% particularly in trade liberalization% but reforms were also implemented in parts of Asia and Africa" /ince then% however% the subse>uent growth rates of many of these restructured economies have significantly underperformed those of other developing nations such as #hina and India" &he comparison with #hina is particularly pertinent when loo ing at issues of political governance% because% although it has become more mar et orientated% it did not follow a similar path to direct privatization and liberalization as those reforming 9atin American nations or of developed economies such as the Inited /tates or the Inited .ingdom" &he #hinese economy has grown rapidly and underta en several reforms over the last decade% and yet it has to a large e$tent retained its planned economy framewor and has only partially adopted aspects of the consensus?for e$ample% by dropping trade barriers in special designated economic zones" &his reinforces the idea there is not one correct route for political governance% but that stability and credibility are critical to mar et development" Fver the last decade or so% emerging mar ets have generally continued to catch up with governance standards in the developed world% and many

countries continue to ma e strides forward" As one e$ample% in Russia many state'owned assets were at least partially privatized after the dissolution of the I//R in the 677;s% where private enterprises were previously difficult to come by% although the outcome of these sales has been controversial" Corporate Governance &he term is an umbrella that covers many issues% including timely accounts% transparency with investors% a legitimate board and growth plan% and the competent management of business operations" &en years ago% most investors would have e$pected the management of emerging mar et companies to be worse than those of developed mar ets in terms of returns to shareholders" In recent years% however% there has been a great deal of convergence% and standards in certain areas of )Ms have even fallen while EMs have improved" /tandards of governance significantly improved in emerging mar ets as capital started to be more liberally deployed across the globe% and with less of a regional or home'country bias% as investors sought new opportunities for alpha or yield" As touched upon in previous sections of this paper% a ey ris facing developing economies is the challenge posed by inflation" Across emerging mar ets% real yields are negative% and indicators li e the &aylor Rule suggest that policy rates are too loose" #redit growth has also been vigorous in many countries" &he implication is that above'trend inflation is a real ris for some emerging mar ets" &he appropriate policy response in this situation is typically to raise interest rates" As it turns out% this is difficult in a world of competing goals held by different policy'ma ers" &he upshot is li ely to be a secular rise in the value of EM currencies% in order to avoid an inflationary spiral or an economic collapse" &he end result is star ? despite its efforts% because it simultaneously tried to maintain a stable fi$ed e$change rate and open capital flows% the EM country was unable to control inflationary pressures in its economy" &he decision it faces is to control capital flows or lose control over inflation" Fr do neither and let its currency appreciate" &he &rireme can be used to reconfigure this narrative in a variety of different ways" 8or e$ample% it can account for countries that may wish to lower rates in response to a demand shoc in their domestic economies" If they do so while maintaining a peg and an open capital account% they will eventually suffer capital flight leading to currency devaluation pressures" 8or some period of time% the central ban may attempt to defend the value of the currency by buying it in the open mar et using 8M reserves" :hen those reserves are e$hausted% as was the case with the Inited .ingdom=s these mitigants often brea down in the medium term" 8M reserve accumulation ris s capital loss if the foreign currency eventually devalues deflates or defaults" #apital control asymmetries suffer from gradual erosion% as discussed below" /terling crisis in 677@% the country has to choose which policy it will abandon" In the short term% the &rireme can be avoided?8M reserves are an e$ample of pushing the problem down the road" Asymmetric capital controls?ma ing it much easier to e$port capital than import it?are another tool"

Conclusions Emerging mar ets have a great opportunity in dominating over 8)I inflows or becoming better nations then the developed nations unless they have transparency in their administrations% opening up of more sectors for investors" If they adopt these measures then they have a pinnacle position in world mar et ahead" In light of our discussion of emerging mar ets% several investment related themes emerge across different asset classes that we believe merit emphasis" Fn a more optimistic note% the ne$t decade will be mar ed by new global leader companies emerging from inside these countries to (oin the e$isting group of such leaders from more developed mar ets" /uccess stories will be (oined by new names in industries such as pharmaceuticals% machinery and food manufacturing" E>uities N we believe that brand'name companies with strong competitive domesticLregional positions and some significant barrier to entry ,this would include )M companies such as +urberry and )aimler- will continue to prosper" N :e suggest that investors see out potential or actual world leader companies with a sustainable technological edge" N :e believe that companies with limited competition by virtue of domestic business conditions ?particularly certain frontier mar et companies?will do well" N :e would suggest avoiding financial companies in countries where financial capital flows are material" N Greater #hina represents an important growth theme% in our view" +eneficiaries in this theme might include &aiwanese domestic financials and /ingapore wealth management ,and the /ingapore dollar-% among other e$amples" N Another potential opportunity% in our view% are the winners from improving corporate governance conditions?Russian e>uities representing a notable e$ample" 8i$ed Income N EM fi$ed income in general can potentially benefit from massive asset allocation shifts in favor of income and carry ,e$cess return- based global investments% and portfolio re'allocations away from developed world investments" N EM fi$ed income also potentially benefits from the favorable demand dynamics given the massive mismatch between potential investable flows and the limited supply of assets"

N :e would caution investors to be aware of sovereigns engaged in measures to regulate capital inflows through various forms of capital controls and the implications for e$pected returns" 1ard #urrency N :e would recommend that investors consider sovereigns with strong balance sheets supported by stable political regimes and prudent policy framewor s" N :e would also suggest that top'tier EM corporate credits in strategic industries represent a compelling opportunity? particularly those that are involved in e$ports% and are consumption based and services driven" 9ocal Mar ets N :e believe that it is very important to determine if you are ta ing interest rate or currency ris when investing in local mar ets" In general% these are currency plays by virtue of their short duration" Interest Rates N :e would suggest investing in high'yielding countries with solid fundamentals" In particular% we recommend focusing on countries that offer positive real rates ,i"e"% return ad(usted for inflation- 8or e$ample% /outh Africa offers positive real rates and good fundamentals" In 9atin America% real rates are higher% particularly in Me$ico and +razil" N :e believe that short'duration fi$ed income has the potential to generate high ris 'ad(usted returns" N :e recommend a focus primarily on the larger mar ets% depending on an investor=s time horizon and li>uidity profile"